Fixing “global imbalances” in three easy steps

Some problems are hard.

Some problems are not, except when we blind ourselves to pretty obvious solutions. Addressing “global financial imbalances”, or, more specifically, the fact that some countries are running persistent current account deficits that they (correctly) perceive not to be in their interest, falls into the second class of problems. It is flawed ideology, nothing more, that makes this problem seem difficult. If you want something to stop, stop it. Let me break it down for you into three easy steps.

  1. Stop blaming China!

    Yes, China’s success at limiting its currency’s real appreciation against the dollar amounts to a combination export subsidy / import tariff, turbocharging China’s tradables sector by making Chinese goods cheap abroad and foreign goods costly to Chinese consumers. The policy has, in some formal sense, robbed Chinese consumers of purchasing power, and shared the loot between Chinese elites and Western consumers.

    But it has also been profoundly good development policy. (See Dani Rodrik.) China’s rise has been miraculous, something that the planet as a whole, and Americans in particular, ought to celebrate. Literally hundreds of millions of people have transitioned from poverty to comfortable modernity. China’s abrupt rise most resembles that of the United States, which went from a civil-war-riven backwater to a dominant world power in only eighty years time.

    I don’t mean to gloss China’s problems or excuse its sins. China’s rise presents huge environmental challenges, to its own people and to the world. I dislike many aspects of its political system. Economically, I’m pretty sympathetic to Tyler Cowen’s China skepticism, and expect that during the continuing economic crisis, a parade of Brobdingnagian boondoggles will come to be revealed.

    Despite all that, in any nondystopian future, China’s gains will be consolidated, not reversed. We should all be rooting for its success. During whatever turbulence lies ahead, we should do everything we can to help.

    I agree with many critics that the combination of China’s currency peg and America’s economic dogma has been harmful to the US. But it is an odd sort of petulance to blame China for acting in its national interest because of consequences that US policymakers have always had the power to prevent. The blame for America’s (very serious) predicament rests squarely with a policy establishment that remained willfully blind to obvious problems for years, and that still refuses to consider effective remedies.

  2. Recognize that a nation’s balance of payments is a legitimate object of public policy.

    Yes, you can write models in which no agent transacts except when doing so is in her infinite-horizon self-interest, in which case policy that restricts or discourages any trade is Pareto destructive, QED. But those models bear little resemblance to the real world.

    In reality, financial flows — trades of promises rather than current goods or services — are subject to unusual uncertainty, and individuals have great difficulty distinguishing advantageous from disadvantageous exchanges. Aggregate financial flows affect both real and financial economies in ways no competent government can afford to ignore. There are reasons why a country might prefer to run a current account surplus or deficit for a while, but that ought to be a considered policy choice. It is rarely sensible for a large, mature, and diverse economy, like that of the United States (or Germany), to run either a deficit or surplus. Persistent trade deficits are a problem for human aggregations of any scale, from family to city to nation-state and beyond. Surpluses are okay at small scales, but become dangerous as they grow. Some groups have reason to oscillate between deficit and surplus, but no sustainable arrangement involves capital flows that never reverse, and whose reversion is not planned for in advance. (This is slightly overstated: a growing economy can sustain persistent small flows indefinitely and maintain a stable net financial position with the rest of the world. For a growing economy, “balance” is a modest range surrounding zero, not a single point. You can also write models — I just did — under which capital flows would never reverse, but the assumptions you need to make are, to say the least, dangerously unreliable.)

    I know of very many arguments that try to justify persistent imbalance, especially persistent deficits. After all, the United States has run very large current account deficits, but its net international position has been relatively stable, because foreigners’ return on their US investments has been abysmal compared to Americans’ return on their gross foreign investment. Also, when a country like the United States, whose debts are incurred in its own currency, runs a trade deficit, it exchanges claims on tokens it can produce indefinitely at zero cost for real goods and services. Why shouldn’t it take the deal?

    These arguments are both ways of saying that some countries, either intentionally or inadvertently, are willing to offer other countries real subsidies mediated and often hidden by complex financial arrangements. But perpetual subsidy is often harmful to the recipient, even if it is willingly offered by the donor. And usually the subsidy is not explicit, so that the donor retains a claim that it expects (however implausibly) to be payable in future goods and services. Arrangements that rely upon systematically reneging on that promise, by perpetually offering poor real returns on creditors,cannot endure, and are likely to be harmful to the spirit of trust and cooperation upon which trade ultimately depends. All financial claims are mere paper, or “spreadsheet entries”. But our ability to sustain economic arrangements that extend over time and geography depend upon our continually giving meaning to that paper by backing our accounts with sweat and treasure. To the degree that we are unable to do so, to the degree that we issue claims that we find ourselves incapable or unwilling to back, we corrode the scaffolding upon which cooperative prosperity depends.

    To be clear, this does not mean that issuers of financial claims should be bound, come what may, to deliver on those claims. Promises, including bad promises, are always joint projects of a promisor and promisee. There may be times and places where the burden of trying to make good on bad paper exceeds the costs, particular and general, of reneging. We are living through those times in very many places, and we are witnessing the consequences — a corrosion of trust, a diminishment of enterprise. The point here is to recognize that promises are fragile but essential. An environment in which promises made are generally kept, in letter and in spirit and without duress, is crucial to organizing the vast collaborations without which we are naked and cold. Persistent net capital flows imply some group of people accepting a flow of current goods and services in exchange for ever more expansive promises to reciprocate at some time in the future. That may occasionally be justifiable, but it is always dangerous, and ought to be subject to very careful scrutiny. When bad promises are made and broken, the consequences are rarely limited to the foolish transactors. The “externalities” can be severe.

  3. Gradually impose nondiscriminatory capital controls to regulate ones own balance of payments

    Fundamentally, there are two ways a country can regulate its international balance. It can target the “current account” or the “capital account”. Managing one takes care of the other as a matter of course. The current account is dominated by the trade balance — the gap, if any between the value of a nation’s imports and exports. The capital account is equal and opposite: if a nation has imported more than it has exported, it has “paid for” the difference with promises. To accept a promise in exchange for present value is to supply capital. Simplifying a bit, a nation receives capital to the degree that it accepts imports in excess of exports, and offers financial claims to cover the difference. A current account deficit implies a capital account surplus, which sounds nice but is nothing more than a windfall of promises yet to keep.

    Traditional protectionism — trade restrictions like tariffs and duties — target the current account. They alter the price of foreign goods and services relative to domestic goods and services, usually making foreign goods more expensive in order to encourage domestic consumption. However, these policies have a deservedly bad reputation. Attaching duties to imported goods and services implies that choices have to be made about how large the duties should be, and to which goods and services they should attach. That discretion generally proves very attractive to politicians, who may reward political supporters with protection of specific industries, skewing consumer choices far beyond the small home bias that might be necessary to manage the balance of payments. In theory, countries might adapt small, perfectly uniform tariffs. But in practice, this never happens, both because the political temptation to pick winners is impossible to overcome, and definitional questions of what ought and ought not be viewed as imports become fraught. (If I buy advertising on a foreign website, is a duty owed?)

    A much better approach is “capital account protectionism”. Rather than getting into the messy business of interfering with the trade in goods and services, manage capital flows directly. The simplest way to do this is to tax (or subsidize) the purchase of domestic financial assets other than zero-interest cash by nonresidents. There need be no interference in Ricardian free trade, the exchange of present goods and services. But the cross-border trade in promises would be taxed and regulated.

    I can already hear the cacophony of objections, and many of them are valid. Yes, clever people would quickly find ways to circumvent a financial asset tax, especially if implemented unilaterally by a single government. (Mutual enforcement would be preferable, but not essential.) Off-balance-sheet arrangements, clever swaps, would have to be controlled (but we have a lot of good reasons to want to do that). Transactions that multinationals now consider “internal” would become more costly and subject to scrutiny (but again, there are lots of reasons to think that supervising “internal” but international corporate flows might be a good idea, given how often these flows are tax motivated). A good regulatory regime combines tactical flexibility with clear goals to which regulators will be held accountable, creating incentives for regulatory innovation to counter circumvention. Those who think capital controls are always futile and doomed to failure are simply wrong. Sometimes they fail, and sometimes they work very well. That capital controls inevitably “leak” is besides the point. Evading controls entails costs and risks that discourage flows at the margin. The point is never to stop flows, but to modulate them. Capital controls that are intended to maintain balanced accounts are more likely to succeed than controls intended to sustain or enlarge imbalances. Also, in a world where disruptive financial flows are increasingly due to the official sector, capital controls are less likely to be actively evaded. A private speculator might hide capital flows in overpayments for current goods (and bear a huge risk of whether her partner will honor her legally unenforceable claim). A foreign government would hesitate to play such games for fear of provoking conflict with the government whose laws it would be flouting.

    Speaking personally, I don’t “like” the idea of capital controls any more than I like trade protectionism. I enjoy the freedom to think globally and invest wherever I choose. But the experience of the developing world for half a century and of the developed world over the last decade ought to have convinced all but the most ideological observers that balance of payment matters; that we cannot expect balance to naturally emerge in global markets; and that relying only on self-correction means tolerating massive-scale waste of real resources while flows persist, then indiscriminate destruction and human misery when flows reverse, or when the poor quality of earlier investment decisions becomes revealed. Our choices are to simply accept these costs as the price of freedom, to use the tools of trade protection, or to add a layer of regulation to the financial economy. In a world of bad alternatives, normalizing capital controls is by far the least awful. Capital controls aren’t perfect, but they are much more resistant to corrupt micromanagement than trade controls.

    The process of going from liberal to more managed capital flows won’t be easy, but it needn’t be that hard either. First and foremost, it can be done without sparking trade wars. If a country imposes capital controls to manage its own balance of payments, it needn’t discriminate against any particular foreign power. China (its government or private investors) could continue to buy US Treasuries on precisely the same terms as European investors. The market would determine which flows (of both goods and capital, they are inextricably linked) would continue and which would be blunted based on demand and comparative advantage. In public relations and in fact, managing ones balance of payments wouldn’t be “about” or any particular trade partner, but simply a matter of national prudence. In order to minimize disruption to other economies, a nation could announce a several year timetable over which it would gradually increase controls as necessary to bring its accounts into balance. Rather than the heated rhetoric of trade protection (which usually involves somebody accusing somebody else of cheating or dumping or poisoning), capital account protectors can focus on the hazards of their own financial position, and adopt an apologetic rather than accusatory tone to help trade partners to save face as they find ways to accommodate the adjustment.

Insure depositors, not banks

Raghuram Rajan offers a thoughtful comment on regulating big banks (hat tip Mark Thoma). The upshot is that bigness, interconnectedness, and proprietary trading are difficult to define, and hard caps are likely to be gamed and evaded. Rajan advocates more subtle strategies “such as prohibiting mergers of large banks or encouraging the break-up of large banks that seem to have a propensity for getting into trouble.” That strikes me as weak tea. I’d prefer that regulators explicitly target a diffuse market structure under which any bank can be let to fail, and that they impose graduated-to-prohibitive taxes on a wide variety of markers of bigness and badness in order to meet that target. Successful banks should grow by division rather than accumulation.

Like Ezra Klein, I was especially intrigued by Rajan’s concluding paragraph:

In reality, proposing limits on size and activity is just an attempt to diminish the deleterious effects of another previous and now anachronistic intervention — deposit insurance. When households did not have access to safe deposits, deposit insurance made sense. With the advent of money-market funds, households gained access to near riskless deposits. Money-market runs can be eliminated by marking them to market daily; they do not need deposit insurance. To encourage community-based banks, deposit insurance may still make sense because small banks are poorly diversified and subject to bank runs. But for large, well-diversified banks, deposit insurance merely contributes to excess. We will bail out these banks anyway in a time of general panic. Why encourage the poorly managed ones to grow without market scrutiny by giving them deposit insurance along the way? Why not phase out deposit insurance as domestic deposits grow beyond a certain size? That would be far more effective in reducing risk than size or activity limits, and far easier to implement.

I’ve a bunch of nits to pick with this: money-market funds are not perfect substitutes for state-guaranteed assets, mark-to-market doesn’t limit aggregate risk or prevent runs (it just makes the race to the exit a bit fairer, and the collapse a bit sharper, as everyone learns when to get nervous at the same time). If large numbers of ordinary households, swayed by yield or convenience, hold funds at an uninsured Chase, Citi, or BoA (cue the television commercials claiming “large, well-diversified banks” to be solid as Gibraltar), that fact would make each of those banks individually too big to fail even in the absence of a “general panic”. No system that expects sales clerks and schoolteachers to monitor financial firms is reasonable or politically sustainable. (If ordinary households can’t be persuaded to do without FDIC insurance, Rajan’s proposal would amount to an end of large depository institutions, which wouldn’t be a bad thing. Depositors would migrate to smaller banks, and large institutions would fund themselves as pure-play investment banks, unless regulated by other means.)

Of course I have a better idea. Rather than insuring banks, the government should insure depositors individually for losses they suffer on deposits at any FDIC-approved bank, up to a pretty high limit (say $1 million, indexed to inflation). Ordinary households would be unaffected by this change, as most families hold balances far less than the insurance cap. They could continue to deposit funds at the FDIC-approved bank of their choice without fear. Affluent households would no longer be able to play the wasteful game of evading insurance limits by splitting funds among different types of accounts and institutions. The affluent would be expected to monitor and help discipline the firms in which they invest. This is both fair and politically credible. It’s fair, because pushing wealth forward in time requires hard information work, and those who wish to push a lot of wealth forward (and earn interest on top!) should contribute to the effort. It’s credible, because ex post facto bailouts for underinsured depositors would be a hard sell when the underinsured include only wealthier depositors, who would not be reduced to penury but, at worst, to a level of affluence most households never achieve, simply by maxing out their government insurance.

Insuring depositors rather than banks wouldn’t, and doesn’t purport to, resolve the too-big/bad/sexy-to-fail problem. It would be a modest change that would eliminate some of the gaming that permits affluent investors to shirk their duty of discipline, and that would improve incentives to monitor by reducing the likelihood that notionally uninsured depositors get bailed out. But all of this matters very little in a world where even junior, unsecured creditors of some banks enjoy an implicit state guarantee.

Update History:

  • 27-January-2010, 5:15 a.m. EST: Touched up the text a bit, fixing some awkward sentences. No substantive changes.

A toy model of money, growth, and inequality

I’ve been trying to develop my intuitions about how inequality might affect aggregate growth. It’s not like this is a new question. Theoretical arguments have been made both ways, and an empirical literature found a consensus in the 1990s (inequality looked bad for growth), then squinted harder to find little relationship in the 2000s. For some careful theorizing about how inequality might harm growth, take a look at this paper by Philippe Aghion, Eve Caroli, and Cecelia Garcia-Penalosa (“ACG”). They tell three stories, with very careful models: i) when capital markets are imperfect, inequality might reduce the efficiency of investment, as the less productive opportunities of the wealthy are funded in preference to the more productive opportunities of the poor; ii) the borrowing required to fund investment under inequality impose agency costs, because entrepreneurs expend less effort when the benefits and costs of their labors are shared with financiers; and iii) unequal access to investment opportunities may combine with financial market imperfections to create macroeconomic downcycles during which savings cannot be efficiently invested.

Those are good stories, and there are others. The oldest story has to do with incentives. The traditional notion of a trade-off between efficiency and equity comes from the idea that redistribution blunts incentives to invest and produce. In almost any model, reducing after-tax returns on investment will reduce investment, ceteris paribus. It is worth pointing out that inequality and redistribution are separate questions. Inequality may be harmful (or helpful) to growth regardless of whether redistribution by the state would would be good policy. That lower after-tax investment returns reduce growth doesn’t really tell us all that much about the effect of inequality. Also, incentives swing both ways: see ACG story (ii) above, or models of effort in tournaments (e.g. Freeman & Gelber via Benign Brodowicz and commenter Indy).

Anyway, there are lots of stories. I want to add one more, and illustrate it with a very simple model. My intuition goes like this: when people are relatively poor, they spend nearly all their income on real goods and services with care, in ways that yield positive returns in present and future consumption. As people grow wealthy, they spend an increasing fraction of their wealth on financial assets, purchases of which only imperfectly translate to productive mobilization of real goods and services. To make my life as a modeler easier, I conjecture that financial assets are phenomenally inefficient — not only do they fail to yield any positive return, but the net expenditure of real goods and services for financial assets is “thrown into the sea”. We’ll see that despite this, under not-entirely-outrageous assumptions, it might be optimal for wealthy agents to purchase an ever larger “stock” of financial assets, but that by doing so rather than mobilizing real resources, they exert a drag on aggregate growth. We’ll find that transfers (or zero-interest loans) of real resources from the issuers of financial assets to the relatively poor can restore growth, and be Pareto optimal if no deductions are made from the claims of the wealthy when real resources are transfered to the poor. In other words, printing money and giving it to poor people (who then buy real resources from the rich, who prefer the insurance value of money to the use value of their marginal goods) can be optimal and noninflationary. We’ll also find that if there is a monopoly issuer of conventionally “safe” financial assets, the value of those assets can be kept stable even if the issuer totally wastes the real resources it receives in exchange for them, and even if the waste and “insolvency” of the issuer is widely known. Effectively, an arbitrarily insolvent Ponzi scheme can be sustained indefinitely due to the usefulness of having a conventional financial claim that agents can use to pool idiosyncratic risks which they cannot contract to diversify. However, if the economy suffers a shock deep enough not only to halt but to reverse the steady state net positive flow of real goods and services from the economy, a devaluation (inflation) or collapse might occur.

This is a shitty little model, not anything an economist would take seriously. Like most models, it’s tendentious — I set out to confirm my intuition that inequality dampens growth via a financial channel, and I’ve done so. Nevertheless, this what I’ve been thinking about lately, and it’s led me to some unexpected conjectures about money. Please read it, if you must read it at all, as a sketchy first draft. (i know, i am such a girl i’ll never change the world.)


Here’s the setup. There’s a population of rational, risk-averse, agents. At any point in time, each agent can exchange goods and services with other agents, or surrender some of their stuff to a monetary authority (government/banking system) to build a stock of money. (When agents trade amongst themselves, it doesn’t matter whether they use money as a medium of exchange, any money holdings are transient.) The exchange and use of real stuff yields a positive instantaneous return on average, but is risky: sometimes real activity works out, but sometimes it fails. The exchange rate between money and real goods and services — the price level — is notionally fixed. We’ll return to the question of whether this presumption of price stability is credible (without state coercion), since monetary claims will be backed by nothing. We simply assume that, as our story begins, agents believe the price level to be stable. Therefore, they view money as a risk-free asset (that pays no interest; the risk-free rate in our economy is zero). Money is the only financial asset: agents can’t buy or sell claims on one another’s production. So agents cannot diversify their exposure to the risk of their real projects. They must decide at each point in time how much of their wealth to plow into risky real stuff, and how much to allocate to safe money. By assumption, there is no systematic risk: individual project returns are uncorrelated. Agents seek to maximize return while managing undiversifiable idiosyncratic risk.

Some technical points (you can skip this paragraph!): Because it makes the math easy, I’ll model returns as normal, and individual agents as having “constant absolute risk aversion (CARA / negative exponential) utility”. I don’t think the assumption of normal returns hurts us much. (This isn’t like a pricing model where fat tails can kill us — fatter tails would just make our agents look more risk-averse and hold more money.) The CARA assumption is less defensible for the very reason it makes the math easy: Under CARA utility, an agent choosing between a high-return risky and low-return risk-free asset always wants to hold a fixed quantity of the risky asset. That’s unrealistic — even at high levels of wealth, I think people typically expand their holdings of risky assets in absolute terms as they grow richer, although they diminish risky holdings as a proportion of their overall portfolio. That is, it’d be more realistic to use a DARA/IRRA utility function, but with the ones I’ve tried, the math is too hard. Qualitatively, though, this doesn’t matter very much. If agents increase their risky holdings in fixed proportion with their wealth or faster (CRRA or DRRA preferences) my story on inequality breaks down (or reverses under DRRA). But as long as agents put an ever greater fraction of their wealth into money-like assets as they grow rich (and I think they do, for informational as well as risk-management reasons), the basic results holds. The curves below with “kinks” would be smoother under a more realistic DARA/IRRA utility function, but the qualitative implications would not change.

Without further ado, here are some pictures.

The top graph displays several initial wealth distributions. Imagine a large population of individuals lined up from poorest to richest, with wealth rising from left to right. The flat, red line represents perfect equality. The purple line represents a highly unequal distribution. The bottom graph displays the expected evolution of GDP for each of those distributions. (Curves are matched to income distributions by color throughout.) Eventually the economy reaches a steady state, in this case at GDP of 10 (an arbitrary quantity). But the more equal distributions reach the steady state more quickly than the unequal distributions, because wealthier people exchange part of their wealth for money rather than putting it to productive use in the real economy.

It might seem odd and unrealistic to imagine an economy that just “tops out” and stops growing. This happens because I haven’t modeled technological change. We can easily augment the model with exogenous growth in technology. The easiest way to do that would be to let both investment returns and absolute risk tolerance grow with technology (that is, to let the numeraire be technology adjusted), and set the risk-free rate to the rate of technology growth. Then we get the more comforting graphs below. We could make other choices about how to model technology, “endogenize” it or rethink how technology affects agent preferences, but that’s not what we’re after right now.

Let’s return to the simple, constant-technology model, and see what happens to money. In the graph below, the solid line represents the aggregate perceived wealth of agents in the economy. The dashed line represents real income, GDP, the goods and services that the economy is actually producing. The gap between the solid and dashed line is the stock of money, backed by nothing but nevertheless part of the perceived wealth of agents in the economy.

Note that the money stock grows earlier in less equal economies. This is the “leakage” that slows their growth. But for all economies, money growth is unbounded, while (technology-adjusted) GDP approaches a steady state. That is, for all economies, eventually the stock of money gets to be much, much larger than the capacity of the economy to produce goods and services. Is it rational, then, for agents to keep adding to their money stock? Can this be a stable arrangement?

The surprising answer is yes, as long as there is no other risk-free asset in the economy. By assumption, agents who choose not to hold money bear idiosyncratic risk: the value of their holdings, while expected to increase, fluctuates in a manner that they dislike. As long as all agents treat money — backed by nothing at all — as a risk-free asset, and there are many agents whose risks are uncorrelated, each agent knows with almost-certainty that whenever their real projects fail, others will have succeeded more than enough so that the flow of goods and services to the monetary authority will be more more than sufficient to accommodate their idiosyncratic withdrawals. As long as the net flow into money is positive at all times, the aggregate stock money is irrelevant. Each agent values her own stock of money, and wants more, because the greater her stock, the greater her entitlement to make withdrawals should she encounter a string of bad events. The growing illusion of wealth produces real benefits, by leaving agents less insecure than they otherwise would have been. The economy is effectively a Ponzi scheme that, under our assumptions, never fails. More formally, it is a Nash equilibrium: each agent’s best strategy, under the assumption that other agents treat money as a stable risk-free asset, is to treat money as a stable risk-free asset. This is true even when all agents are fully aware of the Ponzi-ish nature of the arrangement.

Of course, this benign result depends upon several assumptions, some of them not so realistic. We’ve assumed that all real investments are uncorrelated and money is the only financial asset. If real investment returns are correlated — if there is systematic risk — it is possible there would be a period during which there would be more losses than gains on real investments. Then, rather than happily exchanging goods and services for money, agents in aggregate would try to redeem money for stuff that financial asset issuers don’t actually have. What then? Our model can’t help us — its assumptions are violated at this point, money is no longer a risk-free asset. The value of financial assets could simply collapse à la Bernie Madoff. But qualitatively, if agents can be made to believe that money will continue to offer some insurance value (and if the expected return on unplanned real investment is low and/or the risks are high), then real goods and services could become more expensive in terms of money until the net flow into financial assets matched the net flow out. Rather than a collapse, there would be an inflation. Here the stock of money matters: under almost any circumstance, dollars offer diminishing marginal insurance value. If there is a large stock of dollar claims, then the devaluation required to match inflows and outflows would have to be larger, as people would surrender dollars more easily. Fundamentally, the degree of devaluation would depend upon the demand curve for real goods in suddenly uncertain dollars. If confidence is shaken just a bit, or people hold few dollars, then demand might be price elastic, and a small revaluation might lead to zero net redemptions. If confidence is shaken a lot, if people hold large stocks of dollars, if some shock creates inelastic demand for real goods ad services, then the devaluation (inflation) could be large. In ordinary times, the stock of money is mostly irrelevant, and in fact large stocks of unbacked money creates real benefits. But in extraordinary times, when the flow into money fails, the stock of outstanding money contributes to the likelihood that an inflation will be violent. (Unmodeled demographic changes, rather than investment losses, could also lead to net outflows and valuation crises.)

If a monetary authority has taxing power, could it overcome a shortfall of inflows of real goods and services relative to desired redemptions by taxing? Under our framework, that’d be a tricky thing to try to do. Taxing the money balances of the wealthy doesn’t much affect the flow of resources, except for agents who would have sufficient balances to cover idiosyncratic losses other than for the taxation. So taxing the very rich does nothing, except alter notional insurance balances, while taxing those with little savings does reduce some flows out of money by forcing people to bear losses as hits to consumption rather than drawdowns of money balances. The most effective form of taxation, however, would be to force the poor to exchange goods and services for money, and then surrender the money to the state. Tax receipts from the poor are all real — they cannot be satisfied by drawdowns of notional money balances, and they reduce the net imbalance between flows into money and redemptions very directly. In other words, taxes are effective at preventing a monetary crisis only to the degree the are regressive and harmful to growth. Taxes on rich people with large money balances are only effective if they are confiscatory, bringing those money balances to near zero.

What if we reimpose our “no systematic risk” assumption, so we don’t have to worry about shortfalls, but allow there to be more than one notionally risk-free asset? Then our Nash equilibrium becomes potentially unstable. So long as agents expect some net positive flow to all monetary assets, they are indifferent among them. But that indifference means that no barrier prevents agents from withdrawing claims from one monetary asset and exchanging it for another. If agent behavior is not random, if trends or “sunspots” might affect financial asset choices, and each agent would try to choose whatever asset they expect other agents would predominantly choose. There could be inexplicable runs to and from assets, similar to banks runs, except under our assumptions all agents already know that all monies are in some sense equally insolvent. Runs might be random (or based on unmodeled markers of “confidence”), unless and until only one survived.

Now let’s consider alternatives to the assumption that real goods and services exchanged for money are “thrown into the sea”. We won’t relax the deep (and important) assumption that aggregate wealth is not storable: it must continually reproduce itself via investment. So the monetary authority doesn’t have the option of simply holding the “stock” of goods and services it collects to back the stock of money. So what if, instead of throwing the stuff into the sea, the monetary authority just gives it away? Let’s consider two cases. First, suppose the monetary authority disburses the goods and services it receives to “poor” people. Under our assumptions that would be a Pareto improvement over ocean disposal. Aggregate growth is maximized, as in the perfect equality case (as all real resources would be continually reinvested until all agents reach their desired risky asset portfolio). Suppose the monetary authority transfers the real goods and services it receives back to the wealthy people who surrendered them? Under our assumptions, this sets up an endless loop. Wealthy people would rather have money than real goods and services, so they’d just sell the subsidy back for money. (Despite the apparent absurdity of this, wealthy people would prefer to receive transfers than have them go to the poor, as they gain insurance value from the notional money stock they build by continually receiving and selling back goods.) Transfers to wealthy people yield potentially unbounded growth in the stock of (still unbacked) financial assets, while transfers to those poor enough to invest in the real economy yield growth. Once the economy reaches its steady state, there are no growth-enhancing transfer possibilities left; all agents can maintain their desired level of real investment without transfers, and transfers just increase the notional money stock. Assuming that the monetary authority can’t invest on its own account, it has little to do with the stuff it receives other than to throw it into the sea.

Instead of making transfers, the monetary authority could lend the goods and services it receives from the rich to the poor. Under my assumptions, those sufficiently the poor would borrow and profitably invest if the interest rate charged is less than the expected return, and if resources are lent at the risk-free rate of zero, all those who hadn’t saturated their risky portfolio would be willing to borrow, and the growth rate could be maximized. This corresponds to people’s intuition about how a perfect or transparent financial system would behave. (Interestingly, if the monetary authority lends rather than transfers, growth might last a bit longer than in the perfect equality or transfers-to-the-poor cases, as agents would have to generate somewhat more than their own desired wealth, because some real wealth would continually belong to the monetary authority during the growth phase. Once the economy reaches the steady state, if the monetary authority cannot invest on its own account, the real wealth it holds is surplus and can no longer be reproduced, and so must be thrown into the sea.

If we imagine that the monetary authority can and does invest on its own account as well as private agents, then inequality doesn’t matter and the economy grows indefinitely at the rate of expected return on investment. If we imagine that the monetary authority can and does invest on its own account, and earns higher returns than economic agents, then inequality would be positive for aggregate growth. If we imagine that the monetary authority does things that yield no return but enhance private returns on investment (for example, creating public goods with the resources it purchases by issuing money), we can’t make any prediction about the effect of inequality without modeling the details.

Some observations: The true heart of this model is the idea that, beyond a certain level of wealth, people prefer the security of saving to expanding personal consumption. In real life, I think this is true of most, but not all, people. It’s a condition that I used to characterize, back in the optimistic 1990s, as “post-affluence” or “post-materialism”. In the steady state of this model, there is wealth inequality but consumption equality. The formerly rich are somewhat better insured than the formerly poor, and savvy investment choices can further increase agents’ degree of security (or position in status competitions), but people are satisfied with their level of consumption and don’t much alter it. Changes in consumption patterns result from changes in technology rather than idiosyncratic improvements in economic circumstance. I think this is a state of affairs worth thinking about. Again, in reality, people are not identical, both in terms of levels of consumption at which they’d be content and propensity to switch from consumption to savings at high levels of wealth. But in the 1990s, in my little bubble of opportunity-rich tech types, I did wonder whether we might become a “post-affluent” society, something like what the steady state of this model suggests.

One interesting characteristic of this model is that poor immigrants are good for aggregate growth. As the economy grows, agents become rich and content and cease contributing to growth. Importing poor people who are still striving creates growth and increases steady state GDP, but not GDP per capita (although one could posit indirect spillovers from aggregate growth to technological change, public goods provision, or somesuch). I think there’s something to that.


Some semi-technical miscellany

  • For simplicity, we’ve assumed (unrealistically) that all agents have identical preferences and opportunities. They only differ in their level of wealth. In the real world, peoples’ opportunities and risks vary. In the real world, there are a wide variety of financial assets, some financial asset purchases do affect real investment, and people choose to purchase financial assets rather than real assets in order to capture return, not just to hedge the risks of their own real lives. People may choose financial assets over real assets due to informational problems: high return projects may be available, but it may be difficult or costly to discover them. This model assumes all that away. Agents always know the return distribution they face for real investment; both risk and return are constant. In reality you’d expect diminishing marginal returns to risk (for any given search cost). These effects work in different directions: the fact that financial investment does affect growth-producing real investment by business and government means we are likely to overstate the cost of inequality in the model, but the model excludes many reasons for purchasing financial assets, so it potentially underestimates the scale of inefficient financial asset purchases.

  • We haven’t drawn a distinction between wealth and income inequality, because under the assumptions of our model, real income is always proportional to real wealth. However, perceived wealth includes monetary holdings. Under our assumptions, income eventually decreases as a proportion of perceived wealth, as agents invest in nonyielding money. In the steady state, there is perfect income equality, although the rank order of perceived wealth is preserved (in expectation) from the starting distribution.

  • We haven’t drawn a distinction between “consumption” and “investment”. If agents are rational and have time-consistent preferences, the distinction is immaterial: agents make purchasing decisions that yield a stream of consumption over time, and there’s no reason to treat the enabling of consumption at time zero any differently from consumption at time seven as long as the allocation is optimal. We concern ourselves only with “real expenditure”, and the returns thereon. Our intuitions about the distinction between consumption and investment have to do with lived knowledge that people’s preferences are not time-consistent, that it is hard to defer consumption however “rational” that might be. But even intuitively the distinction between consumption and investment is murky. Is eating consumption or investment? On the one hand, to eat is literally to consume. On the other hand, failing to eat reliably leads to reduced future returns on labor. Maybe some minimal “necessary eating” is investment, and the rest consumption? But we have a notion of poor investment for other goods. Why is it better to consider eating dessert “consumption” rather than superfluous and foolish investment?

  • I’ve been very vague throughout about the distinction between “financial assets” and “money”. That’s intentional but sloppy. Money is the purest example of a financial asset arguably backed by nothing, whose issuers (both governments and banks) may waste, lend, or transfer the real goods and services they receive in exchange for the funds they issue. But other financial assets may be similar, if people purchase them because they seem safer than forward-looking personal spending, and if net issuance results in transfers, loans, or manager perqs rather than direct productive investment. Financial assets whose issuance funds the purchase of real capital goods would count as risky investment rather than money in our model. I also need to think about how purchasing appreciated assets in secondary markets fits in: I think there should be something of an equivalence between assets like money whose increase in aggregate value takes the form of new issue under nominal price stability, and less supply-elastic financial assets which see price appreciation rather than new issue.

Read Scott Winship and Mike Konczal on inequality

Check out the very high quality debate on inequality and middle class living standards between Scott Winship and Mike Konczal. Winship (in two posts) suggests that complaints about middle-class living standards over the past three decades are overdone. Konczal rejoins that even if so, during the last decade something changed, with middle-class income stagnating entirely and debt growth accelerating. Plus, he reminds us, many of the gains in middle class household income prior to the millennium were due to women working more rather than increased wages. Finally, he notes that it’s pretty hard to accentuate the positive for the middle class just now, given the impact of the housing bust and recession. Another piece of the puzzle that Konczal doesn’t address here (but has addressed fabulously elsewhere) is Elizabeth Warren’s point that the operating leverage of middle class households — the proportion of their wealth devoted to fixed necessary expenses — has dramatically increased, leaving families more vulnerable to shocks and worse off in risk-adjusted terms than their (modest) income growth suggests. (Hat tip to Rortybomb commenter RW.)

For the point I’d like to get at about the tension between inequality and stable growth, Kumbaya!, I don’t have to take sides. Winship points out that

what has likely happened is that the very top—the top one-half of one percent—has pulled away from everyone else, though the increase from 1980 to 2009 has probably been fairly modest.

The hypothesis I’m playing around with is that income at the top end of the scale, for a variety of reasons, has a harder time reproducing itself than income going to people whose consumption wants are less completely satiated. (Econogeeks — nonsatiation may not mean what you think it means in a monetary economy under uncertainty.) So even “pareto improving” gains at the top may create a problem for sustaining overall GDP growth. Microeconomics and macroeconomics, alas, need not go together in perfect harmony. Things don’t compose.

I still haven’t made that case — I want to stew on it a bit. More soon, I hope.

Links on inequality and the macroeconomy

I am one of those people who thinks that extreme inequality is inconsistent with a healthy economy. I am not here claiming that extreme inequality is morally wrong or unjust (although it may be). I think that inequality is harmful under conventional macroeconomic criteria of sustainable GDP growth with moderate business cycles. Nick Rowe (whom I generally adore) is dead wrong when he writes, “Sure, there might be distribution effects, but distribution effects are the last refuge of a …. person who can’t think up a better argument.” Distributional questions are central to macroeconomics, and underemphasized for reasons that I think are ideological. A good economy must accommodate three coequal but contradictory concerns: incentives, distribution, and dynamism. Pick any two and what you end up with is crap.

Ceci n’est pas an actual blog post. I don’t mean to flesh out an argument here; I am just madly claiming things. But since it will come up, I do want to preempt the “what about China?” complaint. Inequality and strong growth are definitely consistent in open, export-oriented economies, which rely upon discriminating consumers elsewhere to augment domestic demand. But, except for very small economies, this strategy fails the sustainability test. As China is in the process of discovering, large economies can’t rely upon export-oriented growth indefinitely. Eventually they engender hostility and protection among the nations for which they produce and see the claims in which they are paid devalued. (Germany is discovering this as well, in ways that seem more subtle only because they are less widely discussed.)

Perhaps a more nuanced and defensible way to frame the question is this: Can growth and inequality coexist over time without positing continuous capital flows that never reverse (between countries, or between groups within a single country)? Can a “balanced” economy, in which gross credit/debt rises no faster than GDP, be unequal and grow? (Perhaps it is fair to ask whether a “balanced” economy can ever support growth?)

Anyway, that’s too much already. This not-post is intended just as a placeholder for links. I’ve read a bunch of good pieces on inequality and growth recently, but my brain is like a sieve, so I’ll use the “related” box below to maintain a list of bookmarks. Please let me know in the comments what I’ve missed (and accept an apology for the endless omissions). I’ll try to keep updating this for a while.

[Note: My choices regarding what links to include here are likely to be quirky and seem one-sided. Usually when I append links to a post, I try to be fair about including perspectives I disagree with. But the broad inequality debate is more than I want to cover here. I’m interested in the question of how inequality effects macroeconomic stability and growth. Most defenses of economic inequality that I know address different issues, or simply presume that a tension between equality and growth-enhancing incentives outweighs any other effect. So my collection is unbalanced. I want links on the question of whether inequality is destabilizing, or whether inequality suppresses demand, consumption, and market information in ways that impair growth. I am glad to post links on all sides of those questions. I’m aware, by the way, of the (inconclusive) academic literature that tries to relate growth to inequality measures, but I’ve not seen anything that examines 1) the possibility that effects reverse sign — i.e. moderate inequality might be growth supportive while extreme inequality growth destructive; 2) the role of capital flows and/or credit expansion; or 3) long-ish term stability and low frequency crises.]

Norms of credit

Megan McArdle has responded to my earlier piece on strategic default. Before offering a substantive reply, I’d like to emphasize that my piece was not intended as a “slap down”. If there was anything uncivil either in tone or content, I apologize for it. I often disagree with Ms. McArdle, but she is a talented writer whom I’ve enjoyed for years. I’m pleased to be one of her “little chickadees“. I hope she’ll forgive that I chirp and peck.

Moreover, I think I share McArdle’s deep concern, that a collapse in the norms of commerce will leave us with more cumbersome and substantively worse means of regulating ourselves than we’ve had in the past. We disagree, I think, about who is responsible for the putative collapse, how far along it is, and what we ought to do going forward to regain a desirable equilibrium. I think that the collapse is already upon us, and that the proximate cause is a failure by businesses — especially though not uniquely in the FIRE industries — to live up to tacit social bargains. I blame that in part on a corrosive but remunerative ideology that denies those bargains bind at all. I suspect Ms. McArdle would tell a different story.

Communities regulate themselves via a wide variety of tools, ranging formal legal arrangements to unspoken social norms. Laws are much more visible than norms, but norms carry most of the burden of helping us get along. In the language of economists, norms make markets more complete, by rendering practical contracts too complicated and pervasive to be written and enforced by courts. If I lend a friend some money on a handshake, there are a thousand circumstances under which I would agree to delay in repayment, circumstances in which we would both agree that repayment has become justifiably impossible, and circumstances in which my friend might accelerate her repayment and overpay on the interest with gratitude. To delineate all of those contingencies in a formal contract would be impossible, and attempts to do so leave us with phonebook-length legal documents that make a mockery of the phrase “meeting of the minds”.

My view is that a “good society”, both in a moral sense and from the perspective of economic growth, depends much more on the depth and stability of its tacit norms than on its laws and formal institutions. But norms and laws are interrelated. If a society is to be stable, the two must reinforce one another. Norms and laws are complements at a macro level precisely because they are micro-level substitutes. Norms directly substitute for legal text. They “fill in the blanks”, permitting contracts and laws to be concise and intelligible, yet equitable under a wide variety of circumstances. Since legal arrangements that are unintelligible to those they bind cannot be legitimate, the capacity of tacit norms to stand in for textual complexity is an essential complement to a system of laws.

I think the fight over “strategic default” is really about a collapse in the normative arrangements surrounding reputable business. Ideas have consequences, as they say, and I do think that the theory of business that Friedman helped popularize were corrosive. I don’t condemn him personally for that. His views were sincere, and I was once enchanted by them. But we are where we are.

McArdle writes:

[W]e treat business behavior as different from personal behavior…. [W]e’ve lived in a world where profit-maximizing corporations operate by different normative rules from individuals for 150 years. It may be that the norms to which we hold corporations aren’t the right ones — indeed, in the case of things like overdraft fees and credit card rate games, I think it’s very clear that they’re not, and the banks have only themselves to blame when we decide to handle the problem legally instead. But that doesn’t mean that we should therefore abrogate the norms by which our personal lives are conducted.

I think that she is almost right, but she misses something. Businesses have operated and should operate under very different norms than individuals in their interactions with one another. We have, and have long had, the expression “it’s just business”. When spoken by one businessman to another in the context of even a tragic transaction, like calling in a loan that will force a firm to fold, we recognize the words as legitimate, a kind of apology. But if a businessman uses the same phrase while creating trouble for an individual in her role as customer, tenant, or borrower, it marks the businessman as, well, a jerk (to use McArdle’s very excellent descriptor). Behavior at the interface between businesses and individuals in those roles is supposed to be governed by interpersonal rather than intercorporate norms. Expectations of reciprocity still apply. There have always been businesses that sought every legal cover to profitably mistreat people. But such businesses used to be disreputable.

As McArdle acknowledges (I think) with respect to revolving debt, over the past few decades the financial industry has increasingly applied the norms of hard-nosed business to its interactions with customers. Certainly, a home mortgage to an unrelated party is too high value and dangerous a transaction to be regulated by social norms alone. Lengthy contracts are necessarily involved. But that doesn’t absolve a business from its responsibility to craft financial products in a manner that conforms to interpersonal expectations of fair-play. Along a whole variety of dimensions, the financial industry has increasingly violated those expectations. Lenders drafted contracts with fees and other “revenue enhancers” that borrowers are unlikely to fully understand, and profited when borrowers managed them poorly. They enthusiastically marketed loans to individuals whom they were perfectly able to foresee could not easily bear the debt, against collateral whose valuation they knew to be dodgy, then sold those loans via circuitous paths to investors who literally could not know what they were buying. Mortgage lenders suborned appraisers to soothe both buyers and funders with overoptimistic valuations. The normative breakdown went both ways: individuals preyed on businesses too. The gentleman receiving large commissions selling unsuitable loans, perhaps prodding the borrower to overstate his income, may have been betraying his employer (or not, depending on who was ultimately going to bear the risk of the loan). Certainly the ruthless flipper was violating interpersonal norms when she took a mortgage she knew she could not afford, gambling that a huge upside if prices rose was worth a downside limited by non-recourse or bankruptcy. But she was hardly alone, and she could be forgiven for believing that those norms no longer applied at the interface between banks and customers. They did not.

One group of people who did not violate traditional norms during the course of the credit bubble is the ordinary homebuyer who bought at the top of the market without forming an opinion on valuation, trusting market prices and professional advisors. Most homebuyers are not market timers: they purchase when the circumstances of their own lives make homeownership attractive, and take regional prices as given. Certainly the momentum of home prices affected Joe Sixpack’s (or G.I. Joe’s) buy vs. rent decision. Nevertheless, this group had the least culpability for the malfunctions of the credit market yet they are bearing a disproportionate share of the costs. McArdle thinks it would be desirable, from a social perspective, to reinforce norms under which borrowers have a moral obligation to pay. I would rather lenders ensure that loans where it would not be mutually advantageous for the borrower to pay are rare. To uphold McArdle’s norms on the backs of people who were drawn into a speculative bubble not of their making, whose “banking relationship” consists of a note that has been sold and resold multiple times, and whose risks are legally shared with other parties that have not hewn to any standard of good behavior, is simply unjust. Even if they could bear the cost. Even if they buy new furniture with the savings.

I’ll end on an irony. I think that underwater homeowners ought to walk away from their loans for the very same reason McArdle wants us to consider them jerks for doing so. We both want to see norms we consider valuable enforced. I think that banks violated a great many norms of prudence and fair dealing in their practices during the credit bubble, and that they violate the fundamental norm of reciprocity by fully exploiting their own legal rights while insisting that borrowers have a moral obligation not to exercise a contractual option. In order to strengthen norms I consider crucial, I hope transgressors face legal and social consequences (strategic default and reduced shame attached to default) that will alter their behavior going forward. McArdle values a norm that I think most of us share in interpersonal settings, that a person should make every possible effort to pay back money he has borrowed. She also wants to create consequences for transgressors, social costs via a consensus that those who walk away by choice be considered jerks. We have different preferences regarding the kind of world we want our normative frameworks to support: McArdle favors a world with both easy credit and easy bankruptcy. I favor the easy bankruptcy, but not the easy credit. I think that debt arrangements are hazardous and should be entered into only with great care. I don’t consider increasingly leveraged homeownership and aggressively accessible consumer credit to have been positive developments. As a practical matter, I think we must rely on creditors rather than potential debtors to differentiate between wise and unwise loans. So I consider it a feature rather than a bug that holding creditors accountable will encourage them to think twice before sending out convenience checks. Norms, like laws, are always contested. McArdle and I have very different worldviews, and that is reflected in the different norms we are each trying to reinforce.


Afterthoughts: McArdle suggests that in my previous piece, I misread or misrepresented Milton Friedman. I don’t think I have. Interested readers might review Friedman’s essay and decide for themselves. The piece is powerfully argued. Friedman does try to carve out exceptions for “ethical custom” and “deception”, but I don’t think those caveats withstand the force of his argument when there is even a hint of a shade of grey. I’ve written a bit more on this in a comment. (If you are new to Interfluidity, you may not know that the commenters here are far more insightful than the host. The comment sections on the two previous pieces on “strategic default” — here and here — have been excellent.) Also, a while back, The Compulsive Theorist had a couple of good posts on norms and the financial crisis, here and here. Several of the links above are to pieces by Tanta, whom I miss.

Strategic default: a soldier’s perspective

Commenter “Indy” offered the following in response to the previous post on strategic default by underwater homeowners. I think it’s worth a read:

This is an issue I’ve been thinking about for over a year now. I recently returned to my Law / Economics student life from a deployment to Afghanistan with an Army Military Intelligence unit. Prior to the deployment, several of the other officers had been stationed at the height of the housing bubble at facilities located near D.C. in Northern Virginia. They lived in very modest homes which were removed from their workplaces by substantial driving distances, but these homes were nevertheless particularly pricey for someone with a family and on a military salary. The humble homes ate significant chunks out of those salaries as the commutes did to the (already scarce) time these men had to spend with their families.

Such are among the many sacrifices of military life even in peacetime. There are, it seems, a multitude of wealthy lawyers inhabiting the good neighborhoods in the concentric circles of significance around the capitol. There is real irony is how their bidding up of the prices of real estate in order to achieve influence over power has muscled out the very men who are entrusted by the nation to wield it.

Despite the high prices that dominated before the crash, when my friends had reported to their new posts they found the local branches of the nation’s largest bank chains exceedingly eager to “serve” them. The companies offered to loan them (well, “originate”) up to 100% of the asking price plus costs with a minimum of fuss, delay, paperwork, or any other prudent diligence. I had a similar, “Really, is that it? That can’t be right. Are you sure that’s all you need?” experience when I received my mortgage in 2005 from Countrywide. Those were the days.

The officers were also heavily encouraged to dabble in those now infamous Option-ARMs and other dangerous financial “innovations”. The temptation must have been intense, but the men were skeptical, conservative types, and they opted for traditional fixed-rate mortgages. The Army is a place where an officer is busy with planning half of the time and busy ignoring those plans the other half because all one can do is a kind of ad hoc improvisation and adaptation to constantly changing circumstances. In few other places will one learn more about the limits, almost futility, of planning for an unknowable future full of unforeseeable and defined by unintended consequences. The Army depends and thrives on the bravery of the Soldiers and the caution of their superiors. “Safety” is akin to an ideology and a way of life. Likewise, these were brave and safe men who chose safe mortgages that were “safe as houses”.

While we were away, about halfway through our deployment, the crash began and something mysterious had gone horribly wrong with the machinery of America. The small equity positions these men has invested in their respective residences were wiped out in a matter of months. By the time they were close to returning to these homes the men were all badly underwater by over one hundred thousand dollars and, what was worse, the Army had reassigned them. They would be required to move promptly upon redeployment. They were simply not in a position to hold out, wait for prices to go back up in the long term, and continue making monthly payments. Unfortunate professional timing had compelled them to buy at the top and sell at the “bottom”. Wasn’t the avoidance of precisely this “fire sale” scenario the purported rationale for the bailouts of the financial institutions? But no extension for families, it seemed.

So, as the depth of the murky trouble in which they were finding themselves became increasingly clear they all found themselves perplexed as to what to do. Their uncertainty had two dimensions – (1) technical and (2) moral. They asked for my assistance and I tried to explain the little information I had learned about short-sales, negotiated settlements, and other ways of dealing with their banks to offload their properties and debt obligations (Virginia is non-recourse). I explained what I knew about what the various consequences – for example to their credit scores – would likely be.

When they were presented with these various options one course of action usually stood out as an obvious winner when measured purely in terms of their financial self-interest. However, they still wondered which fork in the road was the right one ethically. They had each accumulated a small life’s savings over the course of their careers, and they could decide to hand over the entire family education and retirement fund to the bank or choose one of the legal options that would let them try and keep it. What was the right thing to do? Were their wives and children the “shareholders” of the family, the welfare (to include the financial well-being) of which the preservation constituted the highest ethical goal?

With these men, and with many others I would estimate, they sense a moral dimension that should be addressed in their decision-making but they don’t know how to conduct the ethical analysis. They look for guidance and advice in the words of their acquaintances and the acts of their community and national leaders.

Their instinct was that if they had borrowed money from a friend or a neighbor they would feel a deep, almost sacred, obligation to make good on their debt and pay it off in full plus interest as soon as they could manage it. It would be wrong to stiff the guy next door even if you were in trouble and the law would let you get away with it. Their first impulse was to extend the principle to all debts, including the one on their house. That was, after all, the “right thing to do” as they had been taught by their parents and grandparents.

But then the bailouts with taxpayer money started. The “too big to fail” talk began, and then the wave of foreclosures and layoffs and emerging scandals of the unjust excesses of the financial industry, and so on. And these men began to feel that from the personal scale of their little world, their family was also perhaps “too big to fail” by the forfeit of their hard-won life’s savings.

They also started to question how the bailouts could make sense without some of the benefits flowing to innocent and responsible men such as themselves. They all knew some reckless nut next door who lied on his applications and bought six houses to “flip”, each of which more than double what he could conceivably afford. How could this crazy man be permitted to just abandon ship and mail the keys to the banks? And what about all the people who were getting the “shadow bailout” by “strategically defaulting” and purposefully living rent-free until the day of eviction, sometimes a year later? How is it just that these frauds would be the primary beneficiary of the foreclosure delay acts of the state legislatures? All of sudden, what had seemed moral now appeared foolish, even stupid.

And then it never seemed to end — bailouts for the car makers, countless earmarks, and a thousand inexplicable giveaways in the “stimulus”. And these gentlemen are not economists or political scientists and must distill the message of these actions through our hysterical and hyperbolic press which tells these stories in a way so as to make us terrified and irate.

And the point of all of this is that even the meekest law of real estate finance can have a profound effect on our cultural values. The whole moral universe, in regards to debt, has been overthrown for these good and righteous men with whom I went to war. They started out with an inclination as to what the right thing to do was, and then they were unsure. Then they questioned whether they were just being “suckers” and if there really was any kind of moral question at all given what was happening in the world around them.

I wonder what new moral lessons these men, indeed our whole generation, will now teach our children and grandchildren. I’ll guess that the content of these lessons will not include much sense of moral obligation or sympathy towards banks. Perhaps that’s for the best, moral intuitions being supportive of certain beneficial survival instincts in the modern dog-eat-dog financial world where ordinary folks need be constantly on their guard. I hope it doesn’t spillover, baby-with-the-bath-water-like, and create a generational animosity for a free market economy and open society in general. I also hope they find a way to preserve some space for social interactions involving money that aren’t “just business” and where, indeed, it’s sometimes worthwhile to make an non-mandatory personal sacrifice for no other reason than because its the “right thing to do”.

Strategic default and the duty to shareholders

Megan McArdle thinks strategic default by underwater homeowners is not okay:

I am afraid that I am one of those people who have no patience for people who refuse to pay their debts… There is a sizable school of thought that says why shouldn’t they? They made a contract with the bank under known rules, and as long as they’re willing to pay the penalties, why shouldn’t they just walk away, the way a corporation would? Well, for one thing, companies don’t always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn’t really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible.

I would like to agree with her. I think that if we structured the economy so that I could agree with her, we’d have both a better world and a more prosperous economy.

But, in the world as it is, in this mess as we’ve made it, her position is beyond unfair. Businesses walk away from contracts all the time, whenever the benefits of doing so exceed the costs under the terms by which they are bound. McArdle is certainly right to point out that companies frequently honor costly bargains they could get away with breaking, because their reputations would be harmed by walking away. But, reputational costs are economic costs. They are a part of the cost/benefit analysis that firms use in making decisions. It is not virtue that binds them to keep their word, but medium-term self-interest. Similarly, homeowners consider the hit to their credit rating and potential loss of social standing prior to walking away.

The question is whether debtors should keep paying off loans simply because it is the “right thing to do”, even when, taking all financial and non-financial costs into account, they would be better off reneging. A human being can choose to be “upright” in this way, if she wants. But under the prevailing norms of business, managers of all but the smallest firms can not so choose. To do so would be unethical.

Let’s recall Milton Friedman’s famous essay, The Social Responsibility of Business is to Increase its Profits:

In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers… Of course, the corporate executive is also a person in his own right. As a person, he may have many other responsibilities that he recognizes or assumes voluntarily… He may feel impelled by these responsibilities to devote part of his income to causes he regards as worthy… spending his own money or time or energy, [but] not the money of his employers… [T]o say that the corporate executive has a “social responsibility” in his capacity as businessman…must mean that he is to act in some way that is not in the interest of his employers…spending someone else’s money for a general social interest… Insofar as his actions…reduce returns to stockholders, he is spending their money. Insofar as his actions raise the price to customers, he is spending the customers’ money. Insofar as his actions lower the wages of some employees, he is spending their money. [H]e is in effect imposing taxes, on the one hand, and deciding how the tax proceeds shall be spent, on the other… [He] is…simultaneously legislator, executive and jurist.

In 1970 when Milton Friedman published these words, I think they must have seemed a bit radical and weird. But today this view is triumphant, both in theory and in practice. Mainstream theory and law view a corporation as a “nexus of contracts” between consenting individuals. Firm managers are agents, employed to act in the interest of shareholders. Shareholders are imagined to unanimously share a single goal — maximizing financial value. When a manager acts in a manner inconsistent with that overriding goal, for motives virtuous or vile, she is imposing “agency costs” on her employers, expropriating resources which are not hers. She is behaving unethically.

An individual, on the other hand, is not so conflicted. Her resources are her own. If she acts against her interest, she harms only herself, and most of us agree that there are times that virtue demands she do so (though we’ve no consensus on just when). McArdle can argue that individuals should pay obligations they’d be better off shirking, in the name of a larger, social good. But under the now prevailing view, she can’t ask that of businesses, because that choice is not firm managers’ to make. If managers or some shareholders wish that a costly action be taken in the name of social responsibility, Friedman helpfully reminds us that they “could separately spend their own money on the particular action if they wished to do so.”

In practical terms, exhortations to individuals that cannot apply to firms leave us with what Felix Salmon aptly describes as “the world’s largest guilt trip“:

The result is a system tilted enormously in favor of institutional lenders who exist in a world of morality-free contracts, and who conspire to lay the world’s largest-ever guilt trip on any borrower who might think about joining them in that world. It’s asymmetrical, it’s unfair… no one would expect a capitalist company to behave in the way that individuals are being told to behave…

Individuals must operate in a competitive economic environment dominated by entities constitutionally incapable of overriding self-interest to “do the right thing”. Virtuous individuals can expect no reciprocity from the firms with which they contract. They have two choices: live nobly and get screwed, or adopt the amoral norms of their counterparties. It has taken some time, but we are all coming around to the only supportable view. “It’s just business,” we shrug, even if we never wanted to be businessmen.

At this moment, the amorality of the transactional, profit-maximizing firm has seeped into most of our commercial relationships. This contributed grievously to the financial crisis: employees of Wall Street firms do not view themselves as morally bound to the fate of their employers, but as atoms negotiating the best terms that they can for themselves. When they found themselves able to enter into arrangements that offered irrevocable cash payments against uncertain accounting profits, they did so eagerly. When flippers discovered they could borrow huge sums of non-recourse money for real estate, and capture huge gains with little personal wealth at risk, they did that too. Asking flippers not to put back underwater property is precisely analogous to asking Wall Street whizzes to give back their exorbitant pre-crisis earnings. The latter won’t happen, so the former should not. Given where we are, every underwater homeowner should absolutely act ruthlessly in her self-interest. If that leads to further turmoil and collapse at the banks, so be it. I see no reason why deeply flawed institutions should be sustained on the backs of the virtuous, via a kind of stupidity tax.

It didn’t have to be this way, and going forward, perhaps we can find a way out. As I said at the start of this essay, I’d prefer to live in a world where I could agree with Ms. McArdle. It was not inevitable that we conceive of the firm as a nexus of contracts without agency for moral action except via implausible relegatation to shareholders. That is just one of many possible ideologies, and a rather idiotic one. The core notion that shareholders “own” the firms they fund is, in my view, a poor definitional choice.

But so long as the “social responsibility of business is to increase its profits”, the social responsibility of customers is to look to their own self interest. Even if that means dropping their house keys in the mail and renting the place next door.

Finreg I: Bank capital and original sin

I have always flattered myself that I would someday die either in prison or with a rope around my neck. So I was excited when The Epicurean Dealmaker invited me to write about financial regulation and crosspost at a site called The New Decembrists. But my views on the topic have grown both more vehement and more distant from the terms of the current debate (such as it is), and I’m having a hard time expressing myself. So I’ll ask readers’ indulgence, go slowly, and start from the beginning. This will be the first long post of a series.


Banks are not financial intermediaries. Their role is not, as the storybooks pretend, to serve as a nexus between savers with capital and entrepreneurs in need of capital for economically valuable projects. Savers do transfer funds to banks, and banks do transfer funds to borrowers. But transfers of funds are related to the provision of capital like nightfall is related to lovemaking. Passion and moonlight are often found together, yes, and there are reasons for that. But the two are very distinct phenomena. They are connected more by coincidence than essence.

The essence of capital provision is bearing economic risk. The flow of funds is like the flow of urine: important, even essential, as one learns when the prostate malfunctions. But “liquidity”, as they say, takes care of itself when the body is healthy. In financial arrangements, whenever capital is amply provided — whenever there is a party clearly both willing and able to bear the risks of an enterprise — there is no trouble getting cash from people who can be certain of its repayment. Always when people claim there is a dearth of “liquidity”, they are really pointing to an absence of capital and expressing disagreement with potential funders about the risks of a venture. Before the Fed swooped in to provide, 2007-vintage CDOs were “illiquid” because the private parties asked to make markets in them or lend against them perceived those activities as horribly risky at the prices their owners desired. There was never an absence of money. There was an absence of willingness to bear risk, an absence of capital for very questionable projects.

No economic risk is borne by insured bank depositors. We have recently learned that very little economic risk is borne by the allegedly uninsured creditors of large banks, and even equityholders — preferred and common — have much of the risk of ownership blunted for them in a crisis by terrified governments. The vast, vast majority of bank capital is therefore provided by the state. Prior to last September, uninsured creditors of US banks were providing some capital. Though they relied upon and profited from a “too big to fail” option when buying bonds of megabanks, there was some uncertainty about whether the government would come ultimately come through. So creditors bore some risk. During the crisis, private creditors wanted out of bearing any of the risk of large banks. Banks were illiquid because private parties viewed them as very probably insolvent, and were unsure that the state would save them.

The US banking system was recapitalized by precisely three words: “no more Lehmans”. All the money we shelled out, the TARP, the Fed’s exploding balance sheet, the offered-but-untapped “Capital Assistance Program”, mattered only insofar as they made the three magic words credible. At this moment the Fed and the Treasury are crowing about how banks are now able to “raise private capital” and about “how TARP is being repaid” and “losses on TARP investments will be much less than anticipated”. That is all subterfuge and sleight-of-hand, flows of urine while the beast lumbers on. The US government has persuaded markets that it stands behind its large banks, that despite no legal right to such protection, all creditors will be made whole and equityholders will live to fluctuate another day. Banks have raised almost no private capital, in an economic sense. They have attracted liquidity on the understanding that the government continues to bear the downside risk.

It’s unfair to say that the government now supplies all large bank capital. Stockholders still suffer price volatility and there is some uncertainty that the government will remain politically capable of being so generous. But the vast majority of large-bank economic capital is now supplied by the state, regardless of the private identities and legal forms associated with bank funding arrangements. So long as the political consensus to support them is strong, American megabanks are in fact exceedingly well capitalized, as the US dollar risk-bearing capacity of their public guarantors is infinite. But that is not a good thing.

No iron law of economics ensures that those who bear the risk of an enterprise enjoy the fruit of its successes. Governments have the power to absorb the downside of formally private enterprises (and the libertarian so principled as to refuse a bail-out is very rare indeed). But they have no automatic ability to collect profits or capture gains from organizations that they economically capitalize, but do not legally own. Bearing the downside risk of a project with no claim on the upside is the circumstance of the writer of an option. Private parties who write options, either explicitly or implicitly via credit arrangements, demand to be paid handsomely for accepting one-sided risk. Governments do not. Banks pay deposit insurance premia, but only on a fraction of the liabilities the government guarantees and in a manner that does not discriminate between the prudent and reckless (which creates a public subsidy to recklessness). When governments have lent to banks during the crisis, they have lent at well below the rates even untroubled, creditworthy nonfinancial borrowers could obtain on the market, so that the implicit option premia embedded in credit spreads were somewhere between negligible and negative. Governments paid banks for the privilege of insuring their risks, or to put it more accurately, they acknowledged that they had already insured bank risks and found ways of paying out claims via subsidies sufficiently hidden as to be politically palatable.

As we think about how to regulate banks going forward, we must first be clear about what we are doing. We are negotiating the terms of options that the government will offer to bank stakeholders. It is important to understand that, for both practical and philosophical reasons. As long as the state substantially bears the downside risks of the financial system, by virtue of explicit legal arrangements or de facto political realities, philosophical arguments for deregulation are incoherent. Deregulation is equivalent to a blank check from the state. If you are philosophically in favor of free market capitalism, you must be in favor of very radical changes in the structure of banking, towards a system under which the state would have no obligation to intervene, and would in fact not intervene, to support bank stakeholders even when their enterprise threaten to collapse. The “resolution regimes” currently proposed do not restore “free market” incentives, because those proposals codify rather than forbid state assumption of risk and losses in the event of a crisis. A free market resolution regime would allocate losses among private stakeholders only, and prevent any loss-shifting to the government. For the moment, such a regime, and the structural changes to the banking system that would be required to make it credible, are politically beyond the pale.

So, the options written by government to bank stakeholders will remain in place. All that remains, then, is to negotiate the terms of those options. Framing bank regulation in terms of option contracts underlines a reality that is tragic but true: options are zero-sum games. One party’s benefit is another party’s cost. Very deeply, there is no confluence of interest we can seek between our best and brightest financiers and the public good. Terms that are good for banks are bad for taxpayers. Negotiating the terms of an option with a wealth-seeking counterparty is an inherently adversarial affair. When President Obama is on the phone with Jamie Dimon, do you think he keeps that in mind? A fact of life that our President seems not to enjoy is that while sometimes there are miscommunications that can be resolved via open exchange, sometimes there are genuine conflicts of interest that must simply be fought out. Bank regulation, alas, is much more the latter.

There are indirect as well as direct effects of option contracts, so maybe I’ve framed things too harshly. After all, we allow and encourage formal derivatives exchanges because, even though the derivative contracts themselves are zero-sum, they permit businesses to insure against risks, and that insurance can enable real wealth creation that might not have otherwise occurred. We claim that derivatives markets make indirect positive contributions to the real economy, despite the fact that their direct effect is simply to shuffle money between participants. Banking also just shuffles money around, but we generally think that it enables important business activity. So one might argue that banks and the public have a common interest after all, and smart regulation to evolve could from a more consensual process. But, one would be wrong. We all have a stake in the existence of a payments system, and banks provide one, but managing that is a largely riskless activity, conceptually separable from the lending and investing function of banks. We would also like our economic capital to be allocated productively. But the effect of writing a more bank-friendly options contract is to reduce the penalties for poor capital allocation while enhancing the payoffs to big, long-shot risks. Banks destroy Main Street wealth and create Wall Street crises by making foolish and indiscriminate use of the capital entrusted to them. If we desire a better banking system, we must limit the degree to which private stakeholders can expect to be made whole by the state. With respect to regulation, what’s good for Goldman Sachs is quite opposed to what is good for America. The point of regulating is to align public and private interests by imposing costly limitations on how banks can behave. Indirect considerations of public welfare reinforce rather than reduce the degree to which bank regulation is zero-sum, a fight that pits the health of the real economy against the distributional interests of bank stakeholders.

However, there is some light in the bleakness. Once we understand that we are negotiating option contracts, we can look to some guidance from the private sector. Option-like private contracts are negotiated all the time, and the issues that surround managing them are well understood. A compare-and-contrast of public sector bank regulation and private sector contracts will prove informative. That will be the subject of our next installment.


Acknowledgments: To be acknowledged by me is like being kissed by a putrescent semi-decapitated halitotic zombie creature. Nevertheless, I failed to weave many links into the above, and my thinking on these issues owes a lot to a bunch of people who are smarter and better smelling than me, so I feel duty bound to mention them. In particular, it was Winterspeak and Mencius Moldbug who fully disabused me of the notion that banks are intermediaries between private parties, which pushed me to think more deeply about the meaning of bank capital, and capital in general. Others who have the misfortune of having influenced my thinking on these issues include supercommenter JKH, Economics of Contempt, Wonkess, The Epicurean Dealmaker, James Kwak, Mike Konczal, and John Hempton. (I’m sure there are more I’ve missed: count yourselves lucky!) But the views expressed above are my own, and all of the people I’ve mentioned are far too sensible lend them any credence.

Good financial innovation: small business equity investing

Felix Salmon has been on a tear lately. If you haven’t already, go read his fantastic post on the appalling double standard whereunder human creditors are morally bound to repay all loans while business debtors have a duty to default whenever they find advantage in doing so.

In another great post, Felix quotes commenter Dan, who argues that rather than “lend to a nearly bankrupt and profligate entity” (he means the US Treasury), investors might “learn basics of business and investing and carefully loan out [funds] to local small businesses.”

I love the idea of small business investing, in theory. But I don’t do it, because, in practice, it is time consuming and fraught with economic, legal, and interpersonal risks. One of the sad ironies of our pseudocapitalmarkets is that it is easy for small investors to supply funds to firms that are large and distant, about which we have little unusual insight. But it is difficult to build a diverse portfolio out of local firms we know intimately and have a personal stake in. This is an area where regulation is more a part of the problem than part of the solution: it is prohibitively expensive for the brilliantly run café down the way to meet all the requirements of selling public equity via pink sheets, let alone getting listed on Nasdaq SmallCap and doing an IPO.

In any case, common stock is a poor vehicle for small business investing, because it is nearly impossible to value even with the most elaborate financial reporting, and offers minority investors so weak a claim that thieves and charlatans flock to provide. There is no easier business than selling empty promises for good money. So, in the world-as-it-is, only investors willing to actively participate in a small business (or at least to actively supervise) take equity stakes, while more distant third parties prefer debt, with its promise to pay on time, or else.

But those choices are too stark. Small entrepreneurs would like outside investors to share the risk of building and running a firm in this dangerously uncertain world. They’d like outside investors to make their enterprise more robust. But debt financing magnifies the risks of a living firm. Entrepreneurs share burdens with debt investors only via bankruptcy, or via painful negotiations to forestall bankruptcy.

Outside investors who are enthusiastic about a small business might well be willing to provide the flexibility that entrepreneurs would want, in exchange for a bit of upside. But again, common equity is a nonstarter for passive investors in very small firms. Conventional preferred equity doesn’t work either: preferred investors tend to view nonpayment of dividends as default, and the lack of a legal ability to enforce doesn’t make them happier. Entrepreneurs therefore find preferred equity expensive to raise (especially given the tax disadvantage! see here and here and here and here and here). Since investor expectations of payment don’t correlate with business success, it doesn’t really diminish entrepreneurs’ cash flow risk. Psychologically, since there is unlikely to be liquid secondary markets for microbiz preferred equity, investors won’t perceive much upside in small business preferred: the base case is that dividends are paid on time and as promised, the downside is dividends are skipped and/or the business fails, leaving them screwed. One could try to sell convertible preferred to create upside, but that’s complicated to value, especially given the deficiencies of small business common stock.

If someone devised an equity instrument that would offer stronger, easier-to-value promises than common equity, that would effectively disperse entrepreneurs’ risks while offering investors an upside, that could be efficiently offered in modest chunks small investors could incorporate into diverse portfolios, I think that would be a fantastic financial innovation.

And it wouldn’t even be hard to do. For all the billions Wall Street poured into “financial innovation” over the last decade, investment bankers simply never bothered to try to solve this problem. Keep doing God’s work, Lloyd.

Here’s a sketch, one of many possible ways this circle might be squared. We’ll propose a kind of variable-maturity zero coupon bond. (Zero coupon preferred, really.) Imagine that every dollar of a small business’ operating cash inflow were indexed. That first dollar bill that gets framed and placed on the wall? That’s dollar number one. By the end of the first night of business at the new pub ‘n grub, maybe dollar number 2000 would have slid through the register.

Suppose businesses sold numbered dollars. Dollar number 420,167 has just been rung in. How much would you pay for dollar number 600,000? If you pay 91¢ for that dollar and it takes a year for the business to bring the next ~$180K, you’ve earned a 10% return. If business is great, and it only takes 6 months reach that sales level, then you earn a 20% annualized return. ROI is dependent only on the briskness of sales, something that is tangible and observable, something that customer/investors can understand and estimate. These claims would confer no control rights upon their holders (except potentially when they are in arrears), so entrepreneurs, the residual claimants, would price their goods and services to maximize profits, not revenue. Holders of fixed income / variable term claims would be along for the ride. Assuming a non-wimpy business owner, investors’ best strategy for maximizing the value of their claims is to drum up business, which is a win/win for the entrepreneur and the investor. Investor repayments would naturally correlate with business success: when business is slow, few payments to investors would come due. When business is brisk, lots of claims would mature.

This is the sort of instrument a financial technology start-up could invent and popularize. There’d be lots to think about: you’d want to provide a standardized and trustworthy accounting system to count operating cash flow, you’d want entrepreneurs to state and the system to enforce limits on the “density” of claims that entrepreneurs could sell (to keep incentives intact), you might want to provide (opt-in or opt-out) automatic reinvestment of maturing claims. A firm might permit claims to be redeemed in services rather than in cash on favorable terms, at investors’ option. Etc. At least initially, this kind of scheme would supplement, not replace traditional forms of financing. Businesses would want backup credit lines in case redemptions exceed reinvestment leaving the business starved of capital. But selling dollars of future revenue is simple enough for retail investors, for customers and clients, to understand. It could be implemented cheaply, in a standardized way, that would allow individuals to build diversified portfolios out of small exposures in the businesses they know and patronize. For entrepreneurs, it would offer a means both of raising risk-bearing capital and inspiring customer activism on behalf of the business.

Maybe this is a workable idea. Maybe not. But I am sure that the problem it tries to address is not intractible, or even that hard. If the brilliant minds behind the structured finance revolution would devote one or two percent of their synapses to inventing alternative forms of small business finance, we might find that the self-induced catastrophes of the legacy banking system needn’t translate into depressions for entrepreneurs and small businesses and all the people they employ.

Update History:

  • 01-December-2009, 6:05 a.m. EST: I’ve made a bunch of small edits over the night — nothing substantive, but every time I read through this I think it’s terribly written and want to rework an awkward phrase or sentence.